Question 2 (35 marks)

PQR Co manufactures glass bottles for the drinks industry. It has been in the business for 15 years. In the past the company has been relying on bank loan for financing its business. In the near future, the company is expected to grow by 7 to 8 percent a year. The CEO of the company is considering to issue corporate bonds to finance its future expansions. He has asked you to help him in the issue and gathered the following information:

(1) A share of 5 year 4.25% coupon Treasury note is sold at $1033.86.

(2) A share of 10 year 4.25% coupon Treasury note is sold at $1020.08.

Both of the T-notes have $1000 par value.

The CEO determines to issue bonds with par value $1000 each, an annual coupon rate of 5% and maturity of 10 years from today. It is also estimated that the liquidity and default risk premium is 2% for PQRs bond.

d. The investment banker estimates that PQR could sell a 5-year, 7% annual coupon, convertible bond for its $1000 par value. The convertible bond could be converted into 40 shares of PQR stock at the owners option. The current stock price is $20, and is expected to grow at a constant rate of 7%.

(1) What is the conversion price? (1 mark)

(2) What is the implied value of the convertibility feature per share? (5 marks)

(3) What is the expected before-tax cost of convertible? (5 marks)